RRSP or TFSA?

First, let’s take a step back and talk about why this question is even important.

An Investing Bootcamp student email the following question last week:

I have a quick question about maxing out your rrsp’s and tfsa.. are those not generally mutual funds managed by a bank with high fees?

…and my answer was:

No, no, but that is a common misconception.

RRSP and TFSA are just buckets that you put investments into, like checking accounts or savings accounts. But in a checking account or a savings account, you can only hold cash.

In an RRSP or a TFSA, you can hold cash, ETFs, stocks, bonds, GICs, and yes, even mutual funds. The issue is that when you go to a bank to open a TFSA or RRSP, they will most often sell you high fee mutual funds. That is probably where part of the misconception is.

Which is just to point out that before we get into the differences between RRSP and TFSA, I want you to understand that each starts out as an empty account that you add investments into.

Think of each like a make-up bag, where you are allowed to put any kind of makeup—lipstick, eyeshadow, mascara, bronzer, eyeliner, etc. etc.

Believing that:

a) RRSPs are mutual fund accounts you get at the bankor
b) TFSA is a savings account that pays very low interest

…is not helpful to the conversation. While both statements can be true, it is like saying you have a bag that can only hold eyeshadow.

That’s not true.

You could throw some other stuff in there if you wanted to. (and if your makeup bag is anything like my make-up bag, you did, and now the bottom is a scary, scary place…)

Also, you can open an RRSP account or a TFSA account in many places: the bank, a fund company, a full-service brokerage, a discount (DIY) brokerage, etc. The investments you put in the accounts are your choice.

OK, with that out of the way, let’s get to the meat of this article (tofu, if you are a vegetarian!)

Let’s start with explaining the acronyms:

An RRSP is a Registered Retirement Saving Plan, and a TFSA is a Tax-Free Savings Account.

Both are provided by the Canadian government as incentives for Canadians to save, primarily for retirement, but the TFSA can also be used for short-term savings (i.e. emergency fund) or mid-term savings (i.e. home ownership or University).

I would say the most important distinction between the two is:

[+] Money that goes into an RRSP is TAX-FREE and money that comes out of a TFSA is TAX-FREE.

And therefore: money that is withdrawn from an RRSP will be taxed, and money that is contributed to a TFSA will be taxed.

Which means, yes, the key is to have a rough idea of what your income is like today, compared to what you expect it might be in 20 – 30 years (I know, I know—not easy) so that you get the greatest break on your taxes.

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Let’s look at example—meet Betsy:

Betsy is a 24-year-old graphic designer and is employed by The Awesome Shoe Company. She currently earns $38,000 per year but has been taking advanced Photoshop and Web design courses, with the goal of becoming the firm’s Director of Design.

2016 was the first year Betsy earned employment income and so her 2017 RRSP contribution limit is $6,840. (38,000 x .18 = 6,840)*.

Betsy has never contributed to a TFSA and so her allowable contribution limit is $52,000**:

2009: $5,000

2010: $5,000

2011: $5,000

2012: $5,000

2013: $5,500

2014: $5,500

2015: $10,000 (don’t ask, it was a politics thing…)

2016 $5,500

2017 $5,500

= $52,000

Since she started working in February 2016, Betsy has been saving $500/month and now has $10,000 that she is ready to invest.

Which investing account should she choose?

Considerations:

Both the RRSP and the TFSA will allow her funds to grow tax-free.

Contributing $6,840 (the maximum allowable) to her RRSP will reduce her income by the same amount. Assuming a marginal tax rate of 25%, she will receive 2017 refund of $1,710.

Contributing the entire $10,000 to a TFSA will not provide Betsy with any tax relief for 2017.

So, it’s obvious she should contribute to the RRSP, right?

Not so fast.

Betsy needs to consider that she is young and how her future earnings could change over the next decade. For example, if, in the next five years, Betsy’s income grows to $120,000 her marginal tax rate for 2020 could be upwards of 45%.

Assuming at that point, she has $30,000 of unused contribution room in her RRSP, she could split into two contributions 2020 and 2021. Each contribution would be $15,000 and, all things being equal her tax refund for each year would be would be $6,750 for a total of $13,500. (15,000 x .45 = 6,750 x 2 = 13,500)

This example is getting a bit more complicated than I wanted it to be, but my point is that you only get one chance at an RRSP contribution (it is not a finite amount).

As such, it can be best to wait to contribute to an RRSP until you are in a high marginal tax rate. (in Betsy’s case, 45% over 26%)

Pre-2009, this decision had to be weighed against your early contributions not growing tax- free—a compound interest benefit not to ignore. But now, in 2017 your initial funds can grow tax-free in a TFSA, and so the issue is somewhat mitigated.

My advice to Betsy (you know if she was a real person), would be to contribute the entire $10,000 she has for investment in 2015 to a TFSA.

As her income grows, along with her marginal tax rate, she can start adding to an RRSP.

Important Note:

The tax relief you receive from contributing to an RRSP is only deferred.

The idea is that you contribute at a high marginal rate (i.e. 45%), and then you withdraw (at age 71) theoretically paying a lower marginal rate (i.e. 26%).

You base this strategy on the assumption you have a lower income in retirement.

I explain this in much more depth in my free guide (completely revised and updated for 2017):

But there is no way of knowing at age 24 what your income will be in retirement.

It is entirely possible that you will be massively successful, earning $100,000+ year, and thus still paying 45% taxes on your (forced!) RRSP withdrawals.

In comparison, the money withdrawn from a TFSA is not taxed. You already paid tax on the income used to contribute to the TFSA; you did not receive any tax relief on contribution, and so, therefore, it is not taxed again.

Also, you can continue to contribute to a TFSA up until your death. (versus the RRSP that forces you to not only stop participating but also to start withdrawing at age 71).

All this to say that in a perfect world, you will max out both your RRSP and TFSA contributions early and often (and at a high marginal tax rate for the RRSP).

But since the world is rarely perfect, and if you are not in a high tax rate, my vote is for the TFSA.

*Your maximum allowable contribution each year is mandated by the Federal government. The simple calculation is 18% of your previous year’s income, up to a maximum amount of $24,930. As Betsy earned $38,000 in 2014, her maximum allowable contribution is $6,840 (38,000 x 0.18). A couple of notes:

I say simple calculation because, in reality, it is not that simple. Pension adjustments, carry-forward amounts, varying maximum amounts for previous years, etc. can all affect your maximum allowable amount for any given year. Your annual Notice of Assessment (sent you after filing your income taxes each year) will have your next year’s allowable contribution. You can also call the CRA, and after answering 3,251 security questions (LOL), they will provide it to you.

**This amount is also mandated by the Federal government. The TFSA came into effect January 1, 2009. The allowable amounts for every Canadian over 18 are as follows:

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If not used, TFSA amounts also carry forward indefinitely. Meaning, if Betsy (or you) do not contribute in 2017, her (and yours) total allowable contribution will be $52,000.